Great new interview with Nassim Taleb by one of his former teachers at Wharton:

Taleb: The events in the Middle East are not black swans. They were predictable to those who know the region well. At most, they were gray swans or perhaps white swans. One of the lessons of “Wild vs. Mild Randomness,” my chapter with Benoit Mandelbrot in your book, is what happens before you go into a period of wild randomness. You will find a long quiet period that is punctuated with absolute total turmoil…. In The Black Swan, I discussed Saudi Arabia as a prime case of the calm before the storm and the Great Moderation [the perceived end of economic volatility due to the creation of 20th century banking laws] in the same breath. I was comparing Italy with Saudi Arabia. Italy is an example of mild randomness in comparison with Saudi Arabia and Syria, which are examples of wild randomness. Italy has had 60 changes in regime in the post-war era, but they are inconsequential…. It is a prime example of noise. It’s very Italian and so it’s elegant noise, but it’s noise nonetheless. In contrast, Saudi Arabia and Syria have had the same regime in place for 40 some years. You may think it is stability, but it’s not. Once you remove the lid, the thing explodes.

The same kind of thing happens in finance. Take the portfolio of banks. The environment seemed very placid — the Great Moderation — and then the thing explodes.

Herring: I would agree that people knew the Middle East was very vulnerable to turmoil because of the demographics, a very young population, and widespread unemployment, the dissatisfaction with the distribution of income and with regimes that were getting geriatric. But knowing how it would unfold and knowing that somebody immolating themselves in a market in Tunisia would lead to this widespread discontent — and we still don’t know how it will end — is a really remarkable occurrence that I think would be very difficult to predict in any way.

Taleb: Definitely, and it actually taught us to try not to predict the catalyst, which is the most foolish thing in the world, but to try to identify areas of vulnerability. [It’s] like saying a bridge is fragile. I can’t predict which truck is going to break it, so I have to look at it more in a structural form — what physicists call the percolation approach. You study the terrain. You don’t study the components. You see in finance, we study the random walk. Physicists study percolation. They study the terrain — not a drunk person walking around — but the evolution of the terrain itself. Everything is dynamic. That is percolation.

And then you learn not to try to predict which truck is going to break that bridge. But you just look at bridges and say, “Oh, this bridge doesn’t have a great foundation. This other one does. And this one needs to be reinforced.” We can do a lot with the notion of robustness.

The present invention comprises a method using cellular automata to process existing trading data from traders to generate unprecedented output that improves a wide range of future financial trading decisions and alerts for both individual traders and institutions. However, the method and system of the present invention is not a predictive system based on input of market data and it is not algorithmic. Rather, the method and system instead uses cellular automata logic to mimic human trading behavior. Based on the observations of human trading behavior decisions, the present invention generates an output of buy and sells decisions or simply an alert signal. This use of cellular automata as a basis for evaluating trading behavior provides a different basis for generating trading decisions and alerts and forms a new class of financial alerts over the prior art. The method of using cellular automata logic to process financial trading signals is therefore a paradigm shift in the logic behind trading decisions and alerts. It creates a new kind of technical analysis that features cellular automata interacting with human traders and data.

Bitcoin is an open source, peer-to-peer electronic currency created by Satoshi Nakamoto and maintained by a small team of developers. As part of what’s turning into an ongoing series on the distributed Web, I talked to contributor Gavin Andresen about how the software works. This is a technical overview. If you’re interested in an economic or political look at the software, you can read the Wikipedia entry or Niklas Blanchard’s essay on the project.

The story is as follows. Last year, in Davos, during a private coffee conversation that I thought aimed at saving the world from, among other things, moral hazard, I was interrupted by Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States, who tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and Prof. Blinder’s company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.

I blurted out: “isn’t this unethical?” I was told in response, “We have plenty of former regulators on the staff,” implying that what was legal was ethical.

He goes on to note:

The more complex the regulation, the more bureaucratic the network, the more a regulator who knows the loops and glitches would benefit from it later, as his regulator edge would be a convex function of his differential knowledge. This is a franchise. (Note that this franchise is not limited to finance; the car company Toyota hired former U.S. regulators and used their “expertise” to handle investigations of its car defects). […]

The more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

I’ve always wanted to ask him about this apparent contradiction: who exactly is supposed to do this banning of derivatives and why should they be trusted? This article gives some clarity: he thinks there should be rules, but they shouldn’t be overly complex, because that breed corruption.

The idea that we should have hard and fast, clear rules as opposed to “regulation” is supported by the failure of the SEC’s revision of certain firms’ debt-ratio requirements. From Reason:

In 2004, the international Committee on Banking Supervision issued Basel II, an accord on banking regulation. In its wake, the SEC revised its regulations to allow five broker-dealer firms with more than $5 billion in capital—Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley—to participate in a voluntary program that changed the way their debt was calculated. The existing net-capital rules required firms to keep their debt-to-net capital ratios below 12-1 and to issue warnings if they started to get close to that. Under the new rules, broker dealers increased these ratios significantly. Merrill Lynch, for instance, hit 40-1. This was possible because the rule changed the formula for risk calculations and instituted more subjective, labor-intensive SEC oversight in place of hard and fast guidelines. “They constructed a mechanism that simply didn’t work,” former SEC official Lee Pickard told The New York Sun on September 18. “The SEC modification in 2004 is the primary reason for all of the losses that have occurred.”

So I’m guessing Taleb draws a line between banning a practice and “regulating” it – and between having rules that banks must follow and “regulating” them. It’s an interesting distinction and I wonder what other self-styled libertarians would think about it.

Taleb also notes how the debate over government and regulation goes back to Ancient Greece at least – which is a discouraging reminder that almost any modern debate we have on almost any subject goes back for centuries. It’s enough to make you want to live in a bathtub and nourish yourself onions.

Robert Prechter, who uses technical analysis, a theory that holds that there are mathematically computable patterns in the stock market, think’s we’re in for the “big one” in a big way:

Mr. Prechter is convinced that we have entered a market decline of staggering proportions — perhaps the biggest of the last 300 years. […]

Originating in the writings of Ralph Nelson Elliott, an obscure accountant who found repetitive patterns, or “fractals,” in the stock market of the 1930s and ’40s, the theory suggests that an epic downswing is under way, Mr. Prechter said. But he argued that even skeptical investors should take his advice seriously. […]

For a rough parallel, he said, go all the way back to England and the collapse of the South Sea Bubble in 1720, a crash that deterred people “from buying stocks for 100 years,” he said. This time, he said, “If I’m right, it will be such a shock that people will be telling their grandkids many years from now, ‘Don’t touch stocks.’ ”

Bank deposits don’t get people’s hearts pumping, but scratch-off tickets do. The average American household snaps up about $500 annually in lottery tickets, whose appeal is especially strong among those with lower incomes. Some estimates suggest that more than 80 percent of lottery revenue comes from households making less than $50,000 a year — the very people who have the hardest time saving. In fact, 38 percent of people earning less than $25,000 a year think the lottery is the most practical way they’ll accumulate a few hundred thousand dollars in their lifetimes, according to the Consumer Federation of America.

To redirect that money, the credit unions explored how they could blend the excitement of the lottery with the certainty of socking away cash. After all, both are about pursuing aspirations. (One is just a much more fun way to do it.) In January 2009, the credit unions declared that for every $25 someone saved, the saver would earn an entry into a drawing for a $100,000 prize one year later. At the same time, they gave out monthly prizes of up to $100. The credit unions also hoped to attract new members and expand their deposit bases. So as part of the program, people could join a credit union and open an account to bid for the prize at the same time. […]

Yet Save to Win produced stunning results. More than 11,000 Michigan residents opened accounts through the contest, saving $8.6 million throughout 2009. People can open the accounts — they’re like certificates of deposit — with as little as $25. They need to keep their money in for at least a year and can make deposits as small as $1 as often as they like.

Depending on your view, the Bible is divinely inspired or a collection of tall tales. But many see it as a source of financial wisdom that transcends individual faith and the centuries between when it was written and today’s tough times. […]

Purveyors of biblically based financial advice count up to 2,300 verses on money management. Frequently cited verses in the Book of Proverbs urge careful spending, including “The plans of the diligent lead to profit, as surely as haste leads to poverty.” Another warns debtors that “the borrower is servant to the lender.”

Blue sees advice to diversify stock portfolios in a verse about a man’s “bread” from Ecclesiastes: “Give portions to seven, yes to eight, for you do not know what disaster may come upon the land.”

But the many verses can be interpreted in different ways.

For instance, in the Gospel of John, Jesus says, “I have come that they might have life, and have it to the full,” which some “prosperity gospel” preachers see as a promise of material wealth to faithful givers. Others say it’s an assurance of joy or contentment.

Drugs money worth billions of dollars kept the financial system afloat at the height of the global crisis, the United Nations’ drugs and crime tsar has told the Observer.

Antonio Maria Costa, head of the UN Office on Drugs and Crime, said he has seen evidence that the proceeds of organised crime were “the only liquid investment capital” available to some banks on the brink of collapse last year. He said that a majority of the $352bn (£216bn) of drugs profits was absorbed into the economic system as a result.

This will raise questions about crime’s influence on the economic system at times of crisis. It will also prompt further examination of the banking sector as world leaders, including Barack Obama and Gordon Brown, call for new International Monetary Fund regulations. Speaking from his office in Vienna, Costa said evidence that illegal money was being absorbed into the financial system was first drawn to his attention by intelligence agencies and prosecutors around 18 months ago. “In many instances, the money from drugs was the only liquid investment capital. In the second half of 2008, liquidity was the banking system’s main problem and hence liquid capital became an important factor,” he said.

Some of the evidence put before his office indicated that gang money was used to save some banks from collapse when lending seized up, he said.

The main point, he says, is that too often people’s emotions get in the way of clear financial thinking about mortgages, turning them into what he calls “woodheads” — “individuals who choose not to act in their own self-interest.” Most owners are too worried about feelings of shame and embarrassment following a foreclosure, and ignore the powerful financial reasons for going through with it, he said.

Buttressing these emotions is a system that White labels “the social control of the housing crisis” — pressures and messages continually sent to consumers by the “social control agents,” namely banks, government and the media. The mantra these agents — all the way up to President Obama — pound into owners’ heads, White says, is that “voluntarily defaulting on a mortgage is immoral.”

Yet there is an inherent imbalance in the borrower-lender relationship that makes this morality message unfair to consumers: Banks set the rules during the housing boom, handing out home loans with no down payments, no income checks and inflated appraisals. Now that property values have dropped 20 to 50 percent in many areas, banks have been slow to modify troubled mortgages and reluctant to reduce principal debts.

Only when homeowners cut through the emotional fog and default strategically in large numbers, White argues, will this inequitable situation be seriously addressed.

The officials drawn from Wall Street who now control of the Treasury and Federal Reserve repeat the right-wing Big Lie: Poor “subprime families” have brought the system down, exploiting the rich by trying to ape their betters and live beyond their means. Taking out subprime loans and not revealing their actual ability to pay, the NINJA poor (no income, no job, no audit) signed up to obtain “liars’ loans” as no-documentation Alt-A loans are called in the financial junk-paper trade.

I learned the reality a few years ago in London, talking to a commercial banker. “We’ve had an intellectual breakthrough,” he said. “It’s changed our credit philosophy.”

“What is it?” I asked, imagining that he was about to come out with yet a new magical mathematics formula?

“The poor are honest,” he said, accompanying his words with his jaw dropping open as if to say, “Who would have guessed?”

The meaning was clear enough. The poor pay their debts as a matter of honor, even at great personal sacrifice and what today’s neoliberal Chicago School language would call uneconomic behavior. Unlike Donald Trump, they are less likely to walk away from their homes when market prices sink below the mortgage level. This sociological gullibility does not make economic sense, but reflects a group morality that has made them rich pickings for predatory lenders such as Countrywide, Wachovia and Citibank. So it’s not the “lying poor.” It’s the banksters’ fault after all!